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45 Cards in this Set
- Front
- Back
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What is finance?
And what are the two basic principles? |
Finance is the study of making decisions
Time: A pound today is worth more than a pound tomorrow. Risk: a safe pound is worth more than a risky pound. |
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What are the 4 main areas of finance?
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- Corporate Finance
- Investments - Financial Institutions - International Finance |
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What is corporate finance?
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- Undertakes financial decisions for corporations.
ie what long term investments should the firm take on, where to get long-term financing to pay for investments etc. |
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What is investments? (as an area of finance)
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- Work with financial assets such as stocks and bonds
ie how to determine the correct price of stocks and bonds, calculating risk and return, allocation of money into different financial assets. |
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What are financial institutions (as an area of finance)
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- Companies that specialise in financial matters
ie banks, insurance companies |
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What is international finance (as an area of finance)
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- An area of specialisation within each of the other 3 areas
ie for overseas operations, investing in foreign securities |
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What are the 3 areas of financial management decision making?
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Capital Budgeting - How to spend money?
Capital Structure - How to raise money, debt or equity? Working Capital Management - Manage day-to-day cashflow and raise short-term cash. |
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What is an agency relationship?
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A principal hires an agent to represent his/her interests (shareholders and management).
Agents interest might be different from principals goal - "conflict of interest". |
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"When management's interest conflict with that of shareholders" ... Is called?
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Agency cost
Agents interest might be different to principal's goal. This is a result of the agency relationship: whereby someone (principal) hires another (agent) to represent his/her interests. EG - shareholders hiring management. |
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What are the 2 categories of solutions which one can use to align a manager and stockholder interests?
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- Managerial compensation
Incentives such as stock options and bonuses. - Corporate control Internal (replace bad managers) External (threat of takeover may result in better management) |
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What is a financial market?
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Markets where debt and equity securities are bought and sold
Eg - London Stock Exchange (LSE) & New York Stock Exchange (NYSE) |
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In financial markets, what is the primary market?
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Where securities are issued for the first time
- Cashflow between firm and Investor as firm needs money |
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In financial markets, what is the secondary market?
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Where securities are traded between investors
- Cashflow between investor and investor |
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What are the benefits of financial markets?
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For savers - can defer consumption and earn a return to compensate them for doing so.
For borrowers - to have better access to capital so they can invest in productive assets. |
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Describe the 3 levels of return.
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Required Return - What is the minimum return needed to make the investor interested (before buy).
Expected Return - What an investor can expect to earn by buying an asset (if you buy). Realised Return - What an investor actually earned by buying and selling the asset. |
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What is the equation for total (£) pound return?
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= income from investment + capital gain (loss)
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What is capital gain/loss?
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A gain/loss due to the change in price of a security.
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What is the equation for total (%) percentage return?
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Total Return % = Dividend yield + Capital gains yield
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What is the average arithmetic return?
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All returns from years, divided by total years = average return over investment period.
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A reward for baring risk is known as...
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A risk premium.
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What is volatility in finance?
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A statistical measure of the dispersion of returns for a given security or market index.
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What are two methods to measure the volatility of asset returns?
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Variance = VAR(R) or σ2
Standard deviation = SD(R) or σ |
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What's the equation for historical variance?
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Historical V =
Sum of squared deviations from the mean / Number of observations ( - 1 ) |
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What is standard deviation?
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Square root of the historical variance
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How do you calculate geometric returns formula?
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Turn all returns into +1 percentages (9% = 1.09, -7% = 0.93).
Times all these together. Square root this by 1-(the amount of returns) Minus 1 from the result This is the geometric returns percentage. |
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The Efficient Market Hypothesis (EMH) implies:
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- Stocks are fairy priced (nothing over-value or under-value)
- Information efficiency (price incorporates all avail. inf.) - Expected return = required return. |
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Describe the possible stock market price reactions to new information.
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Efficient Reaction - The price instantaneously adjusts and reflects fully new information - no subsequent increases and decreases.
Delayed Reaction - The price partially adjusts, before completely adjusting after a delay to reflect new information. Overreaction and Correction - The price over adjusts to the new information and then corrects itself. |
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What makes markets efficient?
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- There are many investors out there researching
New information comes to the market often, is analysed and trades are based on this information. Prices should reflect all available information. - If investors stop researching or trading securities, markets will not be efficient. |
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What are the 3 forms of efficiency?
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- Strong form
- Semi-strong form - Weak form |
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Describe strong form efficient markets.
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- Prices reflect all information, public and private.
- Investors can not earn abnormal returns regardless of the information they possess. - Empirical evidence indicates that markets are NOT strong form efficient (insiders can earn abnormal sums) |
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Describe semi-strong form efficient markets.
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- Price reflect all publicly available information (annual reports, press releases etc)
- Investors can not earn abnormal returns by trading on public information. - Implies that fundamental analysis will not lead to abnormal returns. |
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Describe weak form efficient markets.
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- Prices reflect all past market information such as price and volume.
- Investors can not earn abnormal returns by trading on market information. - Implies technical analysis will not lead to abnormal returns - Empirical evidence suggests markets are generally weak form efficient |
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What does Efficient Market Hypothesis mean for investors?
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Does NOT mean:
- You can't make money Does mean: - On average, you will earn a return appropriate for the risk undertaken. - There is no bias in prices that can be exploited to earn excess returns. - Market efficiency will not protect you from bad choices if you do not diversify. |
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Compare the legal liability for the three main business structures?
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Sole proprietorship - Unlimited
Partnership - Unlimited Corporation - Limited |
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Compare the continuity of equity for the three main business structures?
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Sole proprietorship - Limited to life of proprietor
Partnership - Limited to life of proprietors Corporation - Unlimited as a separate entity. |
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Compare the capital acquisition possibilities for the three main business structures?
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Sole proprietorship - Limited to what proprietor can raise
Partnership - Limited to what proprietors can raise Corporation - Stocks and bonds, more credible |
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Compare the management culture for the three main business structures?
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Sole proprietorship - One owner, also manager.
Partnership - 2+ owners, often managers. Corporation - Many owners - owner/manager different. (often creates Agency cost). |
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Compare the tax culture for the three main business structures?
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Sole proprietorship - Income/expense reported in personal tax return.
Partnership - Divided among partners as agreed in contract - then reported on personal tax return. Corporation - Separate entity = 2 tax: -Corporation tax on corporation's profits -Income tax on investor's dividends |
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What to debt holders want?
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Repayment of the principle + interest.
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What do shareholders want?
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Dividends + capital gains.
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What should be the goal of a corporation and its management?
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Maximise shareholder value.
(maximise the current value per share of the company's existing stock). |
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Give an example of an agency cost.
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When a manager (agent) wants to spend more time with their families, but the shareholder (principle) wants them to work harder.
= agency cost. = cost of alternative representation. |
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What is the calculation for dividend yield?
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Dividend yield = income / beginning price
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What is the calculation for capital gains yield?
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Capital gains yield = capital gain / beginning price
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Why is geometric better than arithmetic?
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It takes into account the effects of compounding.
Arithmetic does not. 0-20 years use arithmetic 20-40 years split the difference between them 40+ years use geometric |
